On a personal note, as you read this, I will be teaching a Professional Futures Trader course in Minneapolis. As I am the “Trader Biker,” I decided to ride my motorcycle there and use the “Mother Road” Route 66. It should be a fun ride and an exciting time. I’ll update you via my Twitter, Facebook and Power Trading Nation.
I have been receiving many emails about my use of the popular Relative Strength Index (RSI) in my trading. I want to stress that my entries and exits for trades are triggered by price action and I use the core strategy taught at Online Trading Academy in my own trading. The indicators I use are simply an odds enhancer or a support tool.
I wrote an article in March 2011 called, “Use the 60-40 Bounce or Break for Greater Profits.” In that article I mentioned that the RSI will not offer you proper buying or selling signals in strong trending markets. Instead of using the indicator for entry signals, I use it more as a filter to keep me out of trades that are less likely to work.
Let me review what happens with the RSI in strong trends. Most traders are familiar with the Relative Strength Index or RSI. It is an oscillator that measures the strength of up or down moves in price relative to the stock’s previous price movements. The typical readings for this indicator are 70-30. A reading of 70% means that the stock is overbought and likely to drop soon. The RSI crossing below the 70% line is sometimes taken as a sell signal. Conversely, a reading below 30% shows the stock to be oversold and perhaps ready to rise. A buy signal is said to be generated when the RSI crosses above 30.
The problem with using the RSI in this manner is that in a strong uptrend the RSI will typically use 40 as a support level. And when price is in a strong downtrend, the RSI will use 60 as a resistance level. When we are trading in the trend, we want to let our profits run as long as possible and do not want to enter into trades with a low probability of working. We can use the RSI with those new parameters to help us identify some of those opportunities as we approach supply and demand levels. In an uptrend for instance, we want to hold longs as supply breaks and prices move to higher levels. If we see on pullbacks that the price fails to break 40 on the RSI, then you are still in a bullish trend and are likely to break the subsequent supply level. However, if you are looking to buy during a pullback to demand and the RSI is below 40, you may want to pass on the trade or have a closer target since price is less likely to make new highs when/if it bounces.
In a downtrend, we want to let our shorts go as far as possible to maximize profits. When we see rallies in the bearish trend fail to breach the 60 level on the RSI, then we are still in the downtrend and are likely to see prices continue to break demand levels. If we see the RSI moving above 60 when price hits supply, we may want to look for another trade or have shorter targets as price is unlikely to make new lows if it does bounce from supply.
To remember the use of the RSI, I have come up with a saying: “If at demand, the RSI is less than 40 then demand will not stand. And if at supply and the RSI is above 60, then supply is a lie.
Remember to trade with the trend and use price action for your decisions to enter or exit trades. We can use some indicators to assist our trading but never as the decision maker themselves.